Ben Lord, manager of M&G high-interest fund and co-manager of the M&G UK inflation-linked corporate bond fund
In recent years, we have maintained an underweight position in financials, given the huge problems within the sector and Europe’s sovereign debt crisis.
However, since the start of this year, we have felt more comfortable lending to well capitalised institutions. Some of them have taken advantage of improved market conditions, largely resulting from the European Central Bank’s massive liquidity injections, to issue bonds at attractive valuations.
The decision to increase exposure to financials does not mean the risks within the banking system have gone away, so we continue to adopt a relatively cautious approach.
Our increased exposure has therefore been primarily via senior debt instruments such as AAA-rated covered bonds and senior unsecured bonds issued by some of our preferred financial institutions. We have also been operating selectively via small positions in subordinated bonds in stronger names.
In our opinion, some index-linked government bonds currently offer value. Inflationary pressures are likely to ease in the near term but our managers believe the market’s expectations for inflation in the longer-term as measured by break-even rates are too low.
Index-linked bonds therefore offer cheap “insurance” against rising prices in an environment in which central banks are undertaking quantitative easing and similar initiatives that may increase the likelihood of a revival in inflation rates.
Our managers also see value in the inflation-linked corporate bond universe. This market is less developed than its sovereign counterpart but offers compelling diversification and return opportunities and is becoming more established.
Howard Cunningham, portfolio manager, Newton corporate bond fund
We believe corporate bonds still offer an attractive risk-reward trade-off compared with supposedly safer assets such as government bonds or riskier assets such as equities, particularly given uncertainty about interest rate paths and economic recovery.
In many sectors, spreads are as high as in the third quarter of 2009 and higher than for most of the intervening period. The risks of a deflationary, depression-inducing spiral have also reduced. However, many yields are low. This is characteristic of “financial repression” and corporate bond investors are willing to accept low rates in exchange for the relative certainty of returns.
On the other hand, elevated credit spreads provide some cushion against rising gilt yields. For now, companies mostly remain bondholder-friendly.
However, sector and country selection are becoming increasingly important. Investors can avoid sovereign risk by not owning government debt in a highly indebted nation but should not forget about country risk of corporate bonds, such as the political, fiscal and legislative risks of investing in a particular country.
This is because governments have powers not available to other debtors – to tax, change laws and change economic terms of contracts. When governments need to raise revenue, they target those with the means to pay in ways that are hard to avoid. This is as true for companies as for individuals. Utilities may be especially vulnerable.
Furthermore, banks have lobbied successfully to keep their exposure to one another exempt from “bail-in”, citing systemic risk. They are pledging more of their assets as collateral while expecting their clients to still buy their (increasingly subordinated and equity-like) “senior” debt.
Bryn Jones, Rathbone strategic bond fund and Rathbone ethical bond fund fixed-income director at Rathbone Unit Trust Management
US growth prospects look relatively healthy, as do corporate profits. Lead economic indicators are suggesting a bounce, although there has been some sideways movement recently.
European growth is definitely more “sideways”, with problems blighting the periphery and debatable political conviction behind austerity measures.
UK economic data is more positive than not and emerging markets continue to drive global growth. By definition, this is a muddle-through scenario, whereby interest rates will remain unchanged in the short term. This means a carry for bonds, although if and when interest rates rise in 2013/14, investors may swiftly head for the exit.
The other risk is higher inflation which will adversely affect consumer-driven economies such as the US and the UK. We believe the easy money has been made and the credit rally now relies on the direction of company earnings. We are, therefore, more risk-conscious than we were in January and are now recycling cash into residential mortgage-backed securities and retreating up the capital structure. We continue to overweight financials, particularly redeemable bonds.
We are also overweight insurers, a sector that was treated like the banks after 2008, despite getting through the turbulence with few coupon deferrals. Within the insurers, we like those businesses with a strong foothold in the emerging markets, such as Bupa and Standard Life.
Finally, new issues should remain abundant as corporates resort to the bond markets for funding. We continue to watch for opportunities in this space.